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Wage inflation has implications for the UK economy and markets

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15 February 2016

When it comes to economic data, financial markets tend to be more sensitive to how close the numbers are to expectations than the figures themselves. We call this difference the ‘economic surprise’. Statistics about the UK’s labour market have delivered plenty of surprises over the past few years.

As the economy recovered from the 2008 financial crisis, unemployment fell faster than expected (a positive surprise). Meanwhile, GDP growth has fallen short of expectations (a negative surprise). This situation is unusual. When unemployment falls further than expected, the pace of economic growth is usually higher than expected.

The reasons behind this discrepancy are complex and controversial, and there is no consensus among economists. Its longer-term causes lie in flagging productivity growth, private and public sector deleveraging and the hangover from a decade of poor investment decisions before the financial crisis. The meagre rise in wages forms an integral part of this puzzle.

Downward pressure eases

We have identified four reasons that explain why wage growth has been weak. These trends are either slowing or going into reverse, however, so we expect wage inflation to pick up throughout 2016.

First, underemployment has been falling as people working in part-time roles move into full-time jobs. Unemployment has also been dropping with businesses reporting a skills shortage and a high vacancy-to-unemployment ratio. These conditions are combining to push up wages.

Second, research by the US Federal Reserve shows there is a relationship between price shocks — such as the dramatic fall in oil prices last year — and wage inflation. The study also reveals that the impact is temporary, suggesting the downward pressure on wages from lower energy prices will soon end, particularly as the effect of the decline in oil prices should drop out of the year-on-year rate of inflation in early 2016.

Stalling productivity growth is the third reason why wages have not moved much. Businesses need an incentive to hire new workers. Hiring stalled after the financial crisis but this weakness appears to be over after starting to pick up again over the previous two quarters.

Lastly, it is not unusual for wage growth to take time to recover following a deep recession. Many firms reduced headcount following the financial crisis but hoarded the best people, which had a lasting impact on wages. Yet the further we move away from the down years, the less this phenomenon holds back wages.

Wages are on the rise

All four of these factors have continued to dissipate recently and are likely to continue to do so in 2016. Notably, the relationship between underemployment and inflation is not linear. As the economy nears full employment, further tightening of labour market slack should lead to larger increases in wage inflation (figure 1).

What are the implications for financial markets? If higher wages cause inflation to rise more rapidly than expected, the Bank of England could consider increasing interest rates faster than expected. Bond markets would readjust to account for any change in expectations.

Meanwhile, wage inflation is likely to drive a wider dispersion of returns in equity markets. The economy should benefit from any increase in consumer spending, and businesses that have the flexibility to pass on the increase in costs associated with higher wages should do well. At the same time, labour-intensive firms that are unable to increase their prices are likely to lose out.

Figure 1: Output per hour worked

Productivity levels in the UK and US have diverged, but is the UK finally turning the corner?